Freddie, Fannie: No Exit?

We now have the latest plan. The real legacy of the Bush Administration may turn out to be Washington's invasion of financial markets.

Five years from now, we could find ourselves with no exit strategy. My guess is that we'll be pretty much out of Iraq by then. But it would not surprise me to see Freddie and Fannie still in limbo. And who knows whether the Fed's portfolio, which took on some unusual assets with the Bear Stearns rescue, will look more or less exotic than it does today?

The latest plan includes shrinking the portfolios of the two companies by 10 percent per year, starting in 2010. Two big questions:

a) Is the plan to shrink the companies or to shrink their portfolios? Those are not the same. The GSE's do two things. They take default risk, meaning that they issue securities backed by mortgages where any defaults on the mortgages will be made good by the GSE. And they take interest rate risk, meaning that they buy their own mortgage-backed securities and finance them with debt. The latter is what gives rise to what insiders call their portfolios. My point is that they could maintain or increase the share of new mortgages issued for which they provide guarantees, even while shrinking their portfolios. If you really mean to shrink the companies, then you have to go beyond the narrow definition of "portfolio," which in the GSE context usually just refers to interest-rate risk.

b) What is the expiration date on this policy? If it expires next January, with a new Administration, then we may never see a drop in Freddie or Fannie's portfolio, by any definition.

Winston Churchill said that the appeasers had to choose between war and dishonor, that they chose dishonor, and ultimately they would have war. Similarly, our current political leaders had to choose between a financial meltdown and putting the U.S. government firmly behind risky mortgage debt. They chose to meddle, and thereby they have incurred new obligations that ultimately could lead to a meltdown in which the U.S. government itself loses its credit standing.

Comments and Sharing

Sounds like it's worse than even I thought, as I talk about over on my own blog. Seems to me that if we left things alone, the two companies would sell off the mortgages they have in order to stay afloat, which would result in them being smaller and an overall strengthening of the market since the companies that bought up their mortgages would be larger and stronger. There would have been more competition, and that would have been a good thing. Instead we have the government essentially supporting monopoly -- or dioply, in this case.

I guess that the Feds want an entirely non-guaranteed book of business by the successors to Frannie. The government, which can hardly be happy at the thought of another few trillion of debt on its books (the reason these SPVs were created in the first place). Then we'll have some sort of a break up sorta like the breakup of Ma Bell, with a bunch of Baby Fannies.

Each of the Baby Fannies will be subject to the same systemic risk, but in addition, they will be subject to competitive risk (i.e., leveraging themselves as much as possible thru having the highest loan/equity ratios) so that they will be much less prepared to deal with The Next One.

But the loans will all be on a mix of investors all over the world and if half the Baby Fannies default, well, tough.

The unfortunate side effect will be that the US$ will no longer be the reserve or exchange currency of choice, and China, for one, will ... walk... Verrrry... slow....ly... ToTheFIREXEITS to dump its holdings of this stuff. So we need some way to forestall a potential currency crisis of incredible magnitude.

I personally find this Rape of the US creditworthiness the most shameful event by supposedly responsible parties.

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